Momentum (finance)


Momentum (finance)

In finance, momentum is the empirically observed tendency for rising asset prices to rise further, and falling prices to keep falling. For instance, it was shown that stocks with strong past performance continue to outperform stocks with poor past performance in the next period with an average excess return of about 1% per month (Jegadeesh and Titman, 1993, 1999).

The existence of momentum is a market anomaly, which finance theory struggles to explain. The difficulty is that an increase in asset prices, in and of itself, should not warrant further increase. Such increase, according to the efficient-market hypothesis, is warranted only by changes in demand and supply or new information (cf. fundamental analysis). Students of financial economics have largely attributed the appearance of momentum to cognitive biases, which belong in the realm of behavioral economics. The explanation is that investors are irrational (Daniel, Hirschleifer, and Subrahmanyam, 1998 and Barberis, Shleifer, and Vishny, 1998), in that they underreact to new information by failing to incorporate news in their transaction prices. However, much as in the case of price bubbles, recent research has argued that momentum can be observed even with perfectly rational traders (Crombez, 2001).

References

  • Barberis, N., A. Shleifer, and R. Vishny. “A Model of Investor Sentiment.” Journal of Financial Economics, 49, 1998.
  • Crombez, J. "Momentum, Rational Agents and Efficient Markets." The Journal of Psychology and Financial Markets, 2, 2001.
  • Daniel, K., D. Hirschleifer, and A. Subrahmanyam. “A Theory of Overconfidence, Self-Attribution, and Security Market Under and Over-reactions.” Journal of Finance, 53, 1998.
  • Jegadeesh, N., and S. Titman. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 48, 1993.
  • Jegadeesh, N., and S. Titman. “Profitability of Momentum Strategies: An Evaluation of Alternative Explanations.” NBER Working paper #7159, 1999.

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